Betting with Trillions

Prison of Debt Paralyzes West

Be it the United States or the European Union, most Western countries are so highly indebted today that the markets have a greater say in their policies than the people. Why are democratic countries so pathetic when it comes to managing their money sustainably?

By Cordt Schnibben

Friday, 11/16/2012
06:36 PM

In the midst of this confusing crisis, which has already lasted more than five years, former German Chancellor Helmut Schmidt addressed the question of who had "gotten almost the entire world into so much trouble." The longer the search for answers lasted, the more disconcerting the questions arising from the answers became. Is it possible that we are not experiencing a crisis, but rather a transformation of our economic system that feels like an unending crisis, and that waiting for it to end is hopeless? Is it possible that we are waiting for the world to conform to our worldview once again, but that it would be smarter to adjust our worldview to conform to the world? Is it possible that financial markets will never become servants of the markets for goods again? Is it possible that Western countries can no longer get rid of their debt, because democracies can't manage money? And is it possible that even Helmut Schmidt ought to be saying to himself: I too am responsible for getting the world into a fix?

The most romantic Hollywood movie about the financial crisis isn't "Wall Street" or "Margin Call," but the 1995 film "Die Hard: With a Vengeance." In the film, an officer with the East German intelligence agency, the Stasi, steals the gold reserves of the Western world from the basement of the Federal Reserve Bank of New York and supposedly sinks them into the Hudson River. Bruce Willis hunts down the culprit and rescues the 550,000 bars of gold, which, until the early 1970s, were essentially the foundation on which confidence in all the currencies of the Western world was built.

Creating Money out of Thin Air

Until 1971, gold was the benchmark of the US dollar, with one ounce of pure gold corresponding to $35, and the dollar was the fixed benchmark of all Western currencies. But when the United States began to need more and more dollars for the Vietnam War, and the global economy grew so quickly that using gold as a benchmark became a constraint, countries abandoned the system of fixed exchange rates. A new phase of the global economy began, and two processes were set in motion: the liberation of the financial markets from limited money supplies, which was mostly beneficial; and the liberation of countries from limited revenues, which was mostly detrimental. This money bubble continued to inflate for four decades, as central banks were able to create money out of thin air, banks were able to provide seemingly unlimited credit, and consumers and governments were able to go into debt without restraint.

This continued until the biggest credit bubble in history began to burst: first in the United States, because banks had bundled the mortgages of millions of Americans, whose only asset was a house bought on credit, into worthless securities; then around the globe, because banks had foisted these securities onto customers in many countries; and, finally, when these banks began to totter, debt-ridden countries turned private debt into public debt until they too began to totter, and could only borrow money from banks at even higher interest rates than before.

At the moment, the world has only one approach to getting out of this labyrinth of debt: incurring trillions in additional debt.

What does all of this have to do with Bruce Willis and Helmut Schmidt? Willis rescued the world's gold and, with it, the illusion of the good, old world. Schmidt, as Germany's finance minister in the 1970s, set the debt spiral in motion and fueled the illusion in Germany that countries could go into debt, and that this was good for everyone.

When Schmidt's predecessor, Karl Schiller, resigned from the government in protest over 4 billion deutsche marks in new debt, he said: "I am not willing to support a policy that creates the impression that the government pursues the motto: After us comes the deluge."

Schmidt incurred 10 billion deutsche marks in new debt. Inspired by crisis economist John Maynard Keynes, the German government believed that economic stimulus programs would stimulate growth, but only under the condition that the debt was to be brought down again in better times.

This economic policy was known in Germany as "global regulation." As finance minister, and later as chancellor, Schmidt took advantage of the oil crisis to drive up the government deficit with economic stimulus programs. By the time Schmidt stepped down in 1982, annual government spending had tripled relative to 1970 spending, reaching the equivalent of 126 billion ($161 billion), and public debt had increased fivefold, to 313 billion. Today, the combined debt of federal, state and local governments has climbed to more than 2 trillion.

A Human Debt Gene?

From today's perspective -- leaving aside all the effusive rhetoric about Europe -- the introduction of the euro is nothing but the continuation of debt mania with more audacious methods. The euro countries took advantage of the favorable interest rates offered by the common currency to get into even more debt.

Can all of this be blamed on some sort of human debt gene? Is it wastefulness, stupidity or an error in the system? There are two views on how the government should use its budgets to influence the economy: the theory of demand, established by Keynes, advocates creating debt-financed government demand, which in turn generates private demand and produces government revenues. In other words, building a road provides construction workers with wages. They pay taxes, and they also use their wages to buy furniture, which in turn provides furniture makers with income, and so on.

The other view, supply-side economics, is based on the assumption that economic growth is determined by the underlying conditions for companies, whose investment activity depends on high earnings, low wages and low taxes. According to this theory, the government encourages growth through lower tax rates. In the last few decades, the frequent transitions of power in Western countries between politicians who support supply-side economics (conservatives, libertarians and now some center-left social democrats) and those who advocate Keynesian economics (social democrats) has driven up government debt. When some politicians came into power, they reduced government revenues, and when they were replaced by those of the opposite persuasion, spending went up. Some did both.

When the debts of companies and private households are added to the public debt, the sum of all debt has grown at twice the rate of economic output since 1985, and it is now three times the size of the gross world product. Economies in the developed world would appear to require credit-financed demand in order to continue growing -- they need consumers, companies and governments to go into debt and to put off paying for their demand until some unspecified point in the future. Of its own accord, this economic system produces the compulsion to drive up the debt of public and private households.

Governments delegate power and creative force to the markets, in the hope of reaping growth and employment, thereby expanding the financial latitude of policymakers. Government budgets that were built on debt continued to create the illusion of power, until the markets exerted their power through interest.

Interest spending is now the third-largest item in Germany's federal budget, and one in three German municipalities is no longer able to amortize its debt on its own. In the United States, the national debt has grown in the last four years from $10 trillion to more than $16 trillion, as more and more municipalities file for bankruptcy. In Greece, Spain and Italy, the bond markets now indirectly affect pensions, positions provided for in budgets and wages.

A country isn't a business, even though there are politicians who like to treat their voters as if they were employees. Politics is the art of mediating between the political and economic markets, convincing parliaments and citizens that economic policy promotes their prosperity and the common good, and convincing markets and investors that nations cannot be managed in the same profit-oriented way as companies.

After four years of financial crisis, this balance between democracy and the market has been destroyed. On the one hand, governments' massive intervention to rescue the banks and markets has only exacerbated the fundamental problem of legitimization that haunts governments in a democracy. The usual accusation is that the rich are protected while the poor are bled dry. Rarely has it been as roundly confirmed as during the first phase of the financial crisis, when homeowners deeply in debt lost the roof over their heads, while banks, which had gambled with their mortgages, remained in business thanks to taxpayer money.

In the second phase of the crisis, after countries were forced to borrow additional trillions to stabilize the financial markets, the governments' dependency on the financial markets grew to such an extent that the conflict between the market and democracy is now being fought in the open: on the streets of Athens and Madrid, on German TV talk shows, at summit meetings and in election campaigns. The floodlights of democracy are now directed at the financial markets, which are really nothing but a silent web of billions of transactions a day. Every twitch is analyzed, feared, cheered or condemned, and the actions of politicians are judged by whether they benefit or harm the markets.

The attempt by countries to bolster the faltering financial system has in fact increased their dependency on the financial markets to such an extent that their policies are now shaped by two sovereigns: the people and creditors. Creditors and investors demand debt reduction and the prospect of growth, while the people, who want work and prosperity, are noticing that their politicians are now paying more attention to creditors. The power of the street is no match for the power of interest. As a result, the financial crisis has turned into a crisis of democracy, one that can become much more existential than any financial crisis.

From DER SPIEGEL

The article you are reading originally appeared in German in issue 46/2012 (November 12, 2012) of DER SPIEGEL.

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